Initial Public Offering (IPO) is the first step that a company takes from being privately held to publicly listed. When a company is officially listed on bourses, its shares become publicly available for trading. And details of its business dealings are no longer restricted to boardrooms.
Listing allows the companies to tap the public for their capital requirements, breaking their dependence on limited sources of funding. Retail investors can invest in companies that are still early in their life cycle and participate in their future growth stories.
As for the company, it opens up the never-ending source of capital in the form of public investors. With the listing, their financial dealings also become public. It helps them to gain the trust of the financial institutes and debt market for their short and long-term debt requirements.
Companies introduce IPOs due to a variety of reasons. It could be:
1) To raise funds for future expansion,
2) Repay the debt,
3) Allowing exit to existing partners selling off their partial or entire investments,
4) Separate listing of existing subsidies for better business efficiency and value creation,
5) In a few cases, regulators can also make listing mandatory for companies in strategically important sectors.
Challenges of Investing in an IPO
IPOs take place when private entities try to go public. So far, their business dealings have remained private. A retail investor possesses very little information about the company. Hence, it is difficult to make the correct assessment of a company’s health and future perspective.
Factors To Consider Before Investing in an IPO
Despite the lack of information and other challenges, IPOs remain a favourite instrument among investors for their short as well as long-term potential. Here are a few factors that could help investors to make an informed decision.
1) Determining Goals and Time Horizon
Investors must align their objectives with that of the company before investing in an IPO. Are you investing in an IPO to make listing gains? Or, planning to hold shares for a longer period? Investors must be clear about investment goals.
If you are looking to make listing gains, factors like current market sentiments, signals from the grey market, subscription pattern etc., are the important factors that could determine the fate of an IPO.
To make a long-term investment decision, investors will need to consider the overall fundamentals of the company. This includes growth opportunities, financial performance, peer analysis, government policies, possible disruptions, and valuations.
2) Research About the Company
Just like investing in any stock, investors must do thorough research about the company before investing in the IPO for the long term.
Since companies are unlisted, little information is available about them publicly. But, as per the SEBI rules, every IPO-bound company must file a Draft Red Herring Prospectus (DRHP). This document is the best source to accumulate information about the company, its financial performance, growth prospects, threats, and opportunities, etc.
3) Objective of IPO
The objective of the IPO also needs to be carefully interpreted from the information that DRHP provides. If the money is going to be utilised for debt reduction or expansion, it could help the company to improve its financial health and prepare for growth. However, if the fund is not coming to companies and the IPO is being used as a gateway for existing investors, it may not present an attractive opportunity.
Usually, the market is flooded with IPOs when sentiments are bullish and fund flow is extremely high. Under these circumstances, promoters look to offer IPOs at higher valuations. In such IPOs, very little is left on the table for new subscribers.
However, fundamentally strong IPOs can be looked upon as long-term investment opportunities when they are offered at reasonable valuations. Or, wait till they drop to reasonable levels.
4) Valuation of the Issue
Valuation is the most important factor to be considered for making any equity investment. Be it in IPO or regular listed companies.
The best way to evaluate current valuations is to compare them with peers in the listed space. Apart from that, valuations can be compared with listed peers in the international markets as well if no domestic peer is listed on the bourses.
The existing shareholding pattern and possible changes in its post IPO is a good indicator of the company’s objective of bringing an IPO.
If the IPO is in the form of an Offer for Sale (OFS) where promoters are selling their stake, it is not a good signal for the company in the long term.
However, if the company is offering fresh issues where OFS proportion is less, it demonstrates promoters’ faith in the business.
Initial Public Offerings are usually popular among investors due to their ability to generate huge returns around their listing times. However, the risk of it producing large losses is also quite high. Ultimately, investors should judge each IPO based on their fundamentals as well as their motives for going public.